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Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

IRS launches trial of Direct File program

Every tax season brings a host of changes in tax laws, brackets, deductions, and incentives. But this year the IRS has launched a pilot program offering certain taxpayers the ability to complete their simple returns directly through the IRS online portal at no cost. A prototype of the IRS Direct File site went live on March 12 in Tennessee and 11 other states with a goal of attracting 100,000 filers during the beta test phase. The limited experiment will provide valuable data as the service evaluates the potential for wider introduction.

The Direct File pilot is limited to the most basic tax situations including W2 wage income, Social Security benefits, unemployment compensation, and interest income of $1,500 or less. Filers must claim the standard deduction and can report student loan interest or educator expenses and claim child and earned income tax credits. Business and self-employment or gig income is not eligible. DirectFile.IRS.gov is open 24/7 with online customer support available Monday through Friday from 7 am to 10 pm Eastern time.

Millions of Americans choose to enlist aid in filing simple returns due to the perceived complexity of the process, lack of sufficient knowledge, or fear of errors. Even though most lower income taxpayers have access to free assistance, many filers are unaware of these services, or they are inconvenient to access. In addition, some tax preparation services have erected obstacles to free filing, engaging in aggressive upselling and sometimes resorting to deceptive practices to hide no-cost options.

Direct File is intended to provide a free, user-friendly option for uncomplicated tax returns. The Treasury Department estimates that one third of all federal returns could eventually be eligible for direct submission via smartphone, tablet, or computer if the program is expanded nationwide.

The IRS took a stab at simplifying tax filing in 2002. At the initiative of President George W. Bush, the agency adopted a goal of processing 80% of all returns electronically through a partnership including the IRS and 17 tax software companies. By joining the Free File Alliance, preparers agreed to offer free tax preparation and e-filing to the lowest 60% of income earners in exchange for an IRS pledge to refrain from developing its own free system. Yet from the outset, the Free File Program (FFP) experienced limited success in part due to lack of an IRS budget to publicize the program. At its peak in 2005, only 6.4% of eligible taxpayers utilized the program, dropping to 4% in 2020.

Consumer complaints regarding upselling practices, complicated or hidden access to the free service, or deceptive tactics stretch back over several years. A report issued by the Treasury Department Inspector General for Tax Administration found that over 34 million taxpayers eligible for the free filing paid a Free File Alliance member to file their returns in 2019.

The largest tax online preparer, Intuit Inc.’s TurboTax, was recently ordered by the Federal Trade Commission to desist from deceptive advertising practices that claimed taxpayers could file for free even though many customers did not qualify and were directed to paid services. Intuit appealed the FTC order to the US Court of Appeals, calling the decision “deeply flawed”. But this was not the company’s first rodeo; Intuit entered into a 2022 consent agreement to distribute $141 million to settle previous allegations. H&R Block is also the subject of an FTC complaint alleging similarly deceptive representations.

In 2019, some members of Congress introduced legislation to permanently bar the IRS from offering free tax prep services, but the effort collapsed in the wake of media reports highlighting the marketing practices and the declining participation in the Free File Alliance. The same year, the IRS terminated its previous commitment to refrain from building its own basic tax preparation system.

H&R Block and Intuit withdrew from the IRS Free File Alliance in 2020 and 2021 respectively leaving only 8 remaining member preparers in the Alliance. The two firms processed nearly 70% of all returns filed through the program in 2019.

With the network of private sector participants shrinking and an increasing volume of consumer complaints, the Biden administration resurrected consideration of a simplified filing mechanism and included funding for a study and pilot program in the 2022 Inflation Reduction Act. A survey conducted as part of the study found that over 70% of taxpayers said they were very or somewhat interested in such a capability. Subsequent estimates by both the IRS and an independent consultant determined the cost would be relatively modest, as low as $9 per filer with significant participation.

The Taxpayer Advocate Service, ombudsman for the IRS, says the average taxpayer spent 13 hours and $240 on tax preparation in 2022. Americans shell out $104 billion in out-of-pocket costs preparing and submitting tax returns according to the National Taxpayers’ Union.

The largest obstacle to wider adoption of Direct File is the panoply of state taxes. The pilot includes 8 states including Tennessee and Texas with no income tax but involves partnerships with 4 others including New York and California to transfer federal return data directly into those states’ own online filing tools. Further expansion will require additional cooperation but could also lead to greater standardization among state tax filing systems.

The service will evaluate the full results after the end of tax season to determine the future of Direct File, but early reports from the field have been largely positive.

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